This manager’s small-cap fund gave 40% CAGR returns in 3 years

Peppermint Meets Shreedutt Capitalist who looks after more than 50,000 crore equity assets in Canara Robeco Mutual Fund (MF) as head-equity, for his views on what the Fed’s move means for the equity markets. Canara Robeco MF is the 16th largest fund house in the industry and its schemes have been performing well recently. Take the case of Canara Robeco Small Cap Fund managed by Capitalist and Ajay Khandelwal. The scheme has given 40% Compound Annual Growth Rate (CAGR) returns in just three years. In an interview, Capitalist reveals the factors responsible for the fund’s excellent performance. Edited excerpts.

What do you think about the Fed’s guidance that rate hikes may slow from December?

The stance on rate hikes has apparently softened on the back of last month’s data around inflation. Still, the Fed is likely to keep rates high for a long time to focus on reducing inflation. On the margin, this is positive as the Fed chairman’s comments suggest further sharp hikes may not be needed and the terminal rate could be around 5%, rather than the higher trajectory previously expected. This will bring some stability as investors, instead of worrying about incremental rate hikes, will now look for signs of how fast they can break out of the rate-hike cycle. And it will entirely depend on how the monthly inflation print shapes up.

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Your Small-Cap Fund has been one of the best performing funds with 40% CAGR returns over a period of 3 years. What has worked for this fund?

Different funds perform well at different times. There was a time in 2017-18 when our Emerging Equity Fund, which is a large and mid-cap fund, did exceptionally well. We also had a flexi-cap and hybrid fund, which was one of the best performing funds on a 3 year basis. In 2020-21, our Bluechip Fund was one of the best performing funds. This shows the stock-picking abilities of our team, which is reflected in different schemes at different times.

We do not tag ourselves as a fund house having strength in just one particular segment of the market.

Stock selection in a small-cap fund is very important, given the wide universe of companies that a fund manager can choose from in this space. Several sectors in our Small-Cap Fund have contributed to its performance. These are chemicals, capital goods, textile companies, mid-cap and small-cap IT names, industrial names, market infrastructure plays etc. which are not doing well today but have been impressive if you look from the perspective of last three years . ,

What is your overall investment strategy?

Our investment objective is to focus on strong growth oriented businesses run by capable management at reasonable valuations. Ultimately, for wealth creation, you essentially need a capital efficient business, run by a promoter who has both business acumen and integrity. Business acumen, as he has to run the business well and honestly, otherwise he will not share profits with the minority shareholders in a fair manner. We also look for businesses or industries that are scalable. If the size of the industry itself is scalable and the company is gaining market share, this will improve its earnings.

We also love to play turnaround stories. Therefore, we look for long term compounding stories as well as alpha-generators. Alpha-generators are companies that can see potential earnings upgrade due to certain triggers- change in management, change in competitive landscape, change in capital allocation by promoters or operating leverage.

In my belief, the second part of the investment process—filtering—is probably the most important part of alpha-generation. Many investors make a lot of commission mistakes, which is why the filtering step is so important. The error of commission occurs when people invest simply because there is too much buzz or too much interest in a particular sector or stock.

Therefore, in the filtering phase, we try to avoid this. We have built a model with various financial trading parameters and then tested whether the stock meets all these parameters or not. This brings fairness to the process and prevents bad apples – whether it’s a challenging balance-sheet, weak management or poor business quality – from entering our coverage universe.

What has been your most successful stock pick?

There was one company that ran a hospital chain that previously did not qualify for our purposes because it had very low capital efficiency. But, in the last two-three years, promoters have realized that they need to focus on their core business and move away from non-core business. Prior to this, they worked with asset-heavy bookkeepers such as real estate companies, even though their core business was hospital chains. What has changed in the last three years is that most managements have realized that they can only take assets on rent and keep their books asset-light. It was also seen in hotel chains, where we also made a successful selection. We have also made successful choices in industries.

Does the smaller size of the schemes help your fund house to be more nimble as compared to others?

Now, we have plans for some bigger sizes too. Yes, there are still many smaller size plans out there and the smaller size helps to some extent. So, what I tell my investors is that if the size of the scheme is below 1,000-2,000 crores, I can participate in smaller opportunities coming up. For example, a company with a market cap 5,000-7,000 crore would be an acceptable business model and could be included in the portfolio of a smaller scheme.

Also, it will not be possible to add such companies to the portfolio of larger schemes.

However, sometimes larger size can be a blessing. When you’re managing a smaller size plan, you can be less patient. For example, we bought a stake in a company that supplied explosives to industries and the defense sector. But for a long time, the defense side was not playing despite the company investing capital there.

Finally, in early 2021, we sold our position in that stock for approx 1,300 per share. today it is trading over 4,000 each. If it were in a sizable plan, I’d probably be more patient with the company’s performance and keep it in my portfolio. Since it was in a smaller size plan, we walked out as we felt we had waited long enough. The shares were held by the fund house for a long time.

Why did industries do well?

Manufacturing in general has seen a good transformation and we are excited about this space.

We caught this trend long back. Even during the Covid pandemic, their order intake was much better. Covid has adversely reformed balance-sheets, be it related to industry, commodities or banks.

When commodity prices rose, the cash flows of commodity companies improved. Real estate managers were worried during the pandemic, so they liquidated their inventory quickly. As far as construction companies are concerned, the government quickly started clearing their dues. So, in all these sectors, energy, commodities, cement, construction, real estate, etc., cash flow improved for one reason or the other. So, they could delever the balance-sheet faster. Private corporate balance-sheets have changed dramatically through 2020-21. I have not seen such a balance sheet in my career except in 2006-08.

Therefore, when the balance-sheet is present, promoters think of incurring operating expenses (short-term expenses for plant and machinery) even if they do not support capital expenditure (capex). But when promoters see their plant capacity utilization inch-up to near 70%, they also start thinking of fresh capex.

Also, supply chain changes are underway as many companies globally look to move away from China. Therefore, the companies in the manufacturing sector are also benefiting from exports. It also includes auto-assistants.

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